The simple 4-part filter that a legacy fund has used to beat the S&P 500 for over 2 decades

• Hennessy Funds uses a four-step process for fundamental quantitative investing.
• The strategy focuses on mid-cap stocks with specific financial metrics and momentum.
• The fund outperforms benchmarks with a 12.39% annualized return over 21 years.

It's a hard-knock life trying to chase the stock market while balancing the business cycle, inflation, interest rate cuts, and a political environment expected to shift drastically next year.

Investors who weren't spooked by rich mega-cap tech stocks over the past two years did well. Those who threw in the towel might be licking their wounds as growth stocks continue to outperform value dramatically.

But all that matters less to the team at Hennessy Funds, a firm that follows high-conviction investment strategies, rain or shine. While they monitor the macroeconomic environment, they don't sweat the details because they use a simple approach to filter the noise and stick to the fundamentals.

The strategy, referred to as fundamental quantitative investing, isn't the kind done with a computer that rapidly turns over trades. Instead, it builds a simple filter based on backtested factors dating decades to determine the key variables that have worked over time.

For the Hennessy Cornerstone Mid Cap 30 Fund, that filter has been boiled down to a four-step process used for 21 years. It has worked well; the fund has an average annualized total return of 12.39% compared to the S&P 500 at 10.59% and its benchmark, the Russell Midcap Index, at 10.50%.

The method was developed in the 1990s, and Kelley prefers to call it a formula-based approach to avoid mixing it up with modern-day quantitative trading. It takes the emotion and guesswork out of investing.

"We absolutely just let the numbers dictate what we own, and it takes some discipline and it takes some trust in the process," Kelley said. "But we've had some very good success over 21 years."

The 4-step process

Market capitalization between $1 and $10 billion: This starting point simply keeps the focus on small to mid-cap names.

A price-to-sales ratio below $1.50 is a lesser-used multiple than, say, price-to-earnings. Still, it skips the accounting noise that could muddy insight into a business's health because it purely focuses on revenue, which better reflects the core business operation.

"There's not much manipulation you can do to sales," Kelley said. "Like, as a person, you make a salary, and that's very easy to figure out. Well, everything else that happens, if you have investments, if you have capital gains, if you have taxed different things, your bottom line will be much different for me versus you. So the same with a company's income statement, there are a lot of assumptions that can happen."

The dollar value threshold means the fund doesn't want to pay more than $1.50 for every $1 the business makes in revenue.

Once stocks have met the above variables, they are filtered by those with annual earnings higher than the previous year to make sure the company is still growing its bottom line.

The last step is catching upward momentum by filtering for the stocks that have had positive stock price appreciation over the past three and six months.

Often, a stock will hit the bottom and start going up, but there's no way to discern where the absolute bottom will be.

"One of the pitfalls of investing could be essentially catching a falling knife," Kelley said. "And the idea is, 'Oh, this stock looks so cheap, it hasn't been this cheap in 10 years, so I'm going to buy it now'. But unfortunately, if there's something wrong with that stock, if there's some sort of cyclical issue and it's on its way down, it could continue to go down for quite some time. You'll get people shorting it, and a whole bunch of different factors that continue to push it down."

Once a stock has turned the corner and has had upward momentum for three and six months, it's more likely to continue to do well, Kelley said. It's a signal that the overall market has recognized the stock's potential.

By the time the filter process is complete, thousands of US stocks have been filtered down to about 125 to 150, which is still too much. Despite the increased risk, you get more excess returns with a concentrated portfolio. Therefore, they want to stick to 30 finalists. Narrowing from here means picking the stocks with the best performance over the last 12 months or those that have seen their share prices rise the most.

Below are the top 10 holdings of the fund and their weightings as of November 15, 2024. The portfolio rebalances annually.